Lions and Tigers and Cisco Bears! Oh My!

This article is a follow up on our February 12th, 2011 article: “How we lost investor’s money on Cisco”, a title which probably seems even more prescient about now. The article put forth the very unpopular idea that Cisco shares represent both a good value and safe investment, and that an emotional reaction likely played a key role in the recent volatile movements in the share price.

Our opinion hasn't changed. It is not our goal to purchase "at the bottom" nor sell "at the top", for we are not aware of any reliable way to go about doing this (although we are open to suggestions - preferably those that do not involve astrology). Instead, our interests lie in owning good companies, with long-term earning power, that can be purchased at a deep discount.

When the original article above was published on Seekingalpha.com, it received just under 28,000 page views, and over 116 comments (almost all negative). Because giving ourselves a paper cut in the eye and pouring lemon juice on it is only slightly more fun than defending Cisco, and because friends and family have already disowned us over the issue we decided to continue our apology of the firm.

There is a sound argument to be made for buying blue chip, large cap stocks, because they are relatively safe. This is especially true when a company has exhibited consistently strong earnings and can be purchased on a value basis.

For this reason, we decided to look for alternatives to Ciscowhich have similar earnings and value metrics. Starting with a list of some 6,784 issues we applied the following simple filters:

- Market Cap. between 10 bln. and 200 bln.
- Price to book under 2
- Dividend Yield Positive (>0%)
- Operating Profit Margins over 15% (CSCO’s is nearly 20%)
- Net profits margins over 15%
- Price to Earnings Ratio under 15
- Forward Price to Earnings ratio under 10
- Return on Equity over 10%
- Current Ratio over 1

We don’t typically like to use forward P/E ratios, but in the case of large cap. blue chips, whose earnings are stable, there is some validity to this otherwise speculative measure. Considering the "current ratio" is important because it is a measure of a company’s ability to cover immediate costs, and thus is an important characteristic of safety. Despite this, we used a conservative factor of just 1 (Cisco’s Current Ratio is 3.43)

**If we had used a factor of >3 for the "Current Ratio", our query would have produced only one results other than CSCO.

These criteria produced the following 6 results from the original list of 6,784 companies from around the globe:

T.	Company	M. Cap	P/B	Div.	O. Margin	P. Margin	P/E	F. P/E	Ret. on Equity	C. Ratio
PBR	Petroleo Brasileiro	$ 216,118	1.21	0.45%	20.12%	16.22%	8.58	9.11	17.88%	1.9
GLW	Corning Inc.	$ 32,293	1.59	0.97%	26.08%	49.81%	9.35	9.18	19.06%	4.77
TKC	Turkcell Iletisim	$ 12,628	1.95	4.26%	18.47%	18.17%	11.5	9.63	17.59%	2.88
CSCO	Cisco Systems, Inc.	$ 91,765	1.95	1.45%	19.93%	16.78%	13.1	9.71	15.80%	3.43
APA	Apache Corp.	$ 46,884	1.86	0.49%	44.41%	25.94%	13.2	9.31	16.75%	1.01
TEVA	Teva Pharmaceutical	$ 46,535	1.92	1.66%	23.59%	20.67%	13.3	8.7	15.82%	1.36

That is to say about 1/10 of 1% of the publicly listed large cap. companies in the world exhibited approximately the same earnings and value characteristics as CSCO.

**If you don’t feel like investing in companies that operate from countries you've never visited and know almost nothing about (for example issues such as shareholder rights), like say Turkey, than you’re left with only 2 results other than CSCO.

Now we’re just speculating here, but we think there might be a link between the distate directed at CSCO senior management, the historical decline in share price, and emotion based selling. Indeed analysis in the main stream media focuses entirely on the decline in share price over the last 10 years, which is hard to understand as anything other than appealing to the emotions of the crowd. However, presenting only the part of the data which supports your argument is hardly fair. Any discussion of the decrease in share price, which fails to mention the increase in revenues and owner’s equity, is a “straw man”, plain and simple (pun intended). Is it not an error to draw a conclusion from the little evidence the media sound bites have provided? Is it not generalizing from incomplete information? An argument can be won is this way, but is winning an argument the point in investing? Or is “being right” the point? Is it not a logical fallacy to use negative feeling (the media constantly mentions shareholder's lost value) and the historical decline in share price as part of an analysis of the company’s value today? Aren't value and price two entirely and often unrelated issues? (illustrated below)

It is true that CSCO has made errors, but we have found it difficult to uncover “perfect” companies who have not – perhaps such companies do exist. However, If the search for the “perfect” company ends up being an exercise in futility, than CSCO may warrant another look. Their errors in judgment are relatively minor in light of their achievements. This is particularly true when excluding share price declines, (a historical and external phenomenon) a factor that is not necessarily an accurate reflection of the company’s value today, but rather what someone was willing to pay for the shares at some point prior to today. Apparently some were willing to pay dearly in past years for what may have been impossible optimism (see also CSCO’s market cap circa 2000). We have found that this is often the case with technology concerns. Should the prospective buyer or seller of the shares today be a prisoner of past errors in pricing?

What do you mean by “their achievements”?

We mean the following:

1. 11 out of the last 15 quarters CSCO has beat earnings estimates (that’s 73% of the time). The other 4 quarters they met analysts estimates, on remarkably consistent earnings.
2. Revenue has grown from 28.5 bln. in 2006 to 42.8 bln in the last twelve months (an increase of some 50%)
3. Average operating income in the last five fiscal years averaged 23.3% (strong by any measure)
4. Operating cash flow (TTM) was 10.5 bln.
5. In the last five years, owners’ equity has grown from 23.9 bln. to 47.2 bln. (about 100%).

**Although there is room for legitimate conjecture over the question of how to most accuratEly value intangibles (perhaps they are overstated, perhaps they are understated), for our purposes, we’ll take the moderate approach that they are “about right”.

In the previous article, we provided a few simple figures, here are the same figures updated to take CSCO’s Fiscal Q3 into account:

Year	Owners Equity	Market Price @ FYE
2006	$ 23,912,000,000	18.08
2007	$ 31,480,000,000	28.97
2008	$ 34,353,000,000	21.99
2009	$ 38,647,000,000	21.88
2010	$ 44,267,000,000	23.61
**2011 through Q3	$ 47,206,000,000

Avg. 2006-2010
Owner Equity	$ 34,531,800,000
Share Price	22.91
Shares Outstanding	5.95 bln.

As of Today
Owner Equity	$ 47,206,000,000
Share Price	16.52
Shares Outstanding	5.50 bln.

It’s a good thing we’re not smart enough to do higher math, otherwise, we might take something simple (figures above) and make it complicated.

Here is the gist of it:

- The company is selling at a discount of 28% from the 2006-2010 average share price
- There is 450 mln. fewer shares outstanding now than there was on average between 2006 and 2010.
- The company now has about 13 bln. more in equity to strengthen the share price, than it did in aggregate between the same years ( almost 2 bln. more in equity since we published the Feb. 12th article alone).

CSCO is a technology company and technology companies are favorites of speculators and people who understand technology. Is it possible that those who understand technology boldly also make bold investing decisions even if the two competencies are distinct? We have found it is anathema to the true technologist to accept that a technology investment can be great, even if the technology itself is not - it drives true technologist and innovators crazy (we know this because our sponsor tells us we still have to attend our TA meetings, and that we’ll always be “recovering technologists”)

Wall Street may not be the most ethical place in the world

Of course that is just a guess. Speculators frequently trade which is good for brokers – if brokers can have say 500 mln. shares of just one company change hands in just under 7 hours even better (as was the case in the CSCO Q2 earnings announcement). If large shrewd investors want to buy shares of a highly profitable Dow component on a value basis, they would have to first convince a bunch of people to surrender their shares; ideally at a very low price (in other words, precisely when they shouldn't be).

Therefore folks like hedge fund managers (who like to file their 13F’s at the last minute) and retail brokers who make their living from commissions and not investments, have a shared interest in emotional, high volume activity, and the related negative press which sets the whole affair into motion. Negative media sells air time, ratings, page views, shares in companies, and it sells brokerage fees (for which there are little input costs). CSCO may be the target du jour of this coterie, because examples like the other five names above (in a way CSCO's peers) just don’t attract the same type of trader – that is to say, that special breed; the technology speculator.

We have noticed a particular personality trait common amongst traders / speculators of all flavors – they seem to derive excitement from the activity of buying and selling, regardless of whether or not the activity is consistently profitable. For this group, the means has become the end. To the true investor, the activity of “trading” is but a small technical footnote, a non-event as it were, to the abstract activity of capital allocation. The two worlds move at very different speeds. One remarkably slow and calculating, the other is never fast enough.

Unconventional thoughts on value investing

Is it possible than that the best values lay not simply in "boring" companies as the Oracle of Omaha has suggested time and again in his affinity for such things as Jello and furniture, but rather in mature technology companies that are highly profitable, but otherwise boring to the technology faithful, who happen all too often to also be their shareholders? For in these stocks lie the three fold benefits of:

a) A speculative technology crowd unaware and/or perhaps uninterested in fundamentals, and who are anxious to buy or sell on even a slight change in personal sentiment.

b) Impossibly high standards that value investor favorites such as American Express, Coca-Cola and the like are never held to

c) The curious absence of intelligent value investors who are usually busy proclaiming their distinct disinterest in anything vaguely related to technology.

Thus the value-oriented investor in such technology concerns may belong to the smallest club of all. And yet, we know many who can live without Dairy Queen, paint and even insurance, so long as they have high speed data access on their iPhone.

Although the folks in Omaha will protest, it may be that the best values lie not in "unloved, boring stocks", but indeed more particularly in "unloved, boring technology stocks".

Does the punishment fit the crime? The case of HPQ and WMT.

It Depends. Two other American bellwethers - HPQ and WMT (just as CSCO) topped estimates recently but had weak outlooks. Are these two companies not also a reflection of our economy? CSCO, unlike HPQ and WMT has a plan in place to restructure that apparently will be finalized within a blazing 120 days – dead weight like “flip” has already been jettisoned, will HPQ and WMT move as quickly?

If the ancillary thesis in the Feb. 12 article was right, and CSCO is a reflection of our economic dynamism in America, than our choices are limited in how we react to the news today from these two companies who just pulled “a Cisco”, accordingly we can:

1. Draw and Quarter the CEO’s of WMT and HPQ as has been done to Mr. Chambers
2. Forgive CSCO Management for the premium paid by CSCO investors out of the speculative fervor of years past and recognize the superior value in the share price today, particularly on a relative basis.

Neither WMT nor HPQ boasts the earnings power or relative financial strength of CSCO, and yet oddly, both sell at a premium to CSCO? Such discrepancies in price and value confound the value oriented investor, leaving them to believe that in the short term, popularity matters more than the financial score.

If business were about popularity (in the long run) we would concede to our countless detractors, and stop buying CSCO shares. But as it turns out business is about making money last time we checked, so we’re still buying.

CSCO has an enterprise value of only 64.8 bln, with 11% of that value being returned to owners in the last twelve months as 7.2 bln. in Net income. 16.3% of the enterprise value, or 10.5 bln. was operating cash flow in the last year alone.

Alas, we don't expect many to embrace these views, as it turns out, value investing is a lonely business.